L3Harris Technologies, Inc. (LHX) Earnings Call Transcript & Summary

Okay. Good morning, everyone. Thank you for joining us. My name is Pete Arment. I'm Senior Aerospace and Defense Analyst here at Baird and sorry, for the delay, small technical difficulty, but we are obviously delighted to be hosting L3Harris Technologies this morning. And with us from L3Harris, we have Bill Brown, who's the Chairman and Chief Executive Officer; Dave Mulally, Senior Vice President and Chief Financial Officer; and Rajiv Balwani, Vice President, Investor Relations. With that, we're going to jump right into some opening comments from Bill and Phil, thanks again for your time today.

You bet, Peter. Hey, thanks for having us at the conference as well. As many of you saw, we reported third quarter results about 2 weeks ago, and we continue to execute really well. We had strong revenue growth from our core U.S. and international government businesses of about 7%. And we expanded the margin 60 basis points, grew earnings per share by 10% and free cash flow 18% versus last year, all of which put us in a position to raise our earnings per share and free cash flow guide for the year to levels that are consistent with or better than what we laid out pre-COVID, which I think says a lot about the resilience and the determination of the team and the new operating model that we're building here at L3Harris. That strong execution also gave us confidence to return to the capital markets with more than $1 billion in buybacks in the third quarter and now about $2.2 billion expected for the full year. With about $2 billion-plus anticipated in '21, which will supplement with a rising dividend. So as we look forward, we feel really good about our framework of sales up mid-single digits. With steady to rising margins and double-digit earnings and free cash flow per share growth. And we'll firm that up as we release earnings in Q4 -- for Q4 and early -- in late January as well. So with that, Peter, let's take your questions. Thank you.

Yes. Thanks for that, Bill, thank you for the opening comments and an overview kind of how things are exiting Q3. Obviously, we always like to ask about the budgets and perspective. I think when you envision the merger with L3, your focus was more on aligning with the National Defense Strategy and future requirements, not really dealing with thinking about what administration would be in the White House. So thinking about that today, maybe walk through how you're thinking about those primary building blocks that really kind of give you confidence around the mid-single-digit top line growth.

Yes. Sure, Peter. I mean, look, there's obviously a little more volatility in the market with what's happening with the election. We put the merger together without respect to who might be in Congress or the White House. It's more around the threats. It's more about the direction of budget trends and DoD needs, and I think we're well aligned with that. Clearly, with a -- what looks to be a divided government, presuming the Republicans hold the Senate, we're feeling more confident of avoiding any significant policy or budget shifts as well as on the tax side. As you know, we have a CR through December 11. I know there's a lot of work going on in D.C. right now between the House and the Senate to pass on the bills by the end of the year, which if we look at '21, we still expect to be flat with '20 and in line with the budget agreement. So that all feels pretty good. Beyond that, we still anticipate that the DoD budget will remain flattish. As we know that there's rising deficits, they're going to be offset by increasing threats. We know that threats really matter here. So we're looking at more flattish budgets into the future. In terms of priorities, you've heard from President like Biden and what seems to be the person of choice is Michele Flournoy as projected Defense Secretary, we believe that's what's going to end up happening. They both have weighed in on a very strong need for maintaining strong defense and national security. More of a tilt towards technology solution over legacy solutions, which I think supports us. You mentioned about the national defense strategy, certainly supports that near peer threat. The things that they've talked about around artificial intelligence and networks of networks, unmanned systems, resilient communications, cyber, all of those things in a broad C5 ISR domain, which we think we've got a leadership position overall in as well as in each element across all domains. The fight of the future is connected systems. And we feel we're very, very well positioned with the ability to connect across different platforms, 6th gen to 5th gen, 4th gen and across all domains, and we think we're well positioned for that.

Yes. No, that's helpful. You realigned your R&D efforts to kind of extend your position through, I think, some of these investments, I think you talked about in the past, open architecture, that multifunction software-defined technologies. That sounds like it fits right into the technical or the shift to more technical needs going forward.

Peter, this has been a great -- this piece has sort of been under told, if you will, in terms of what we've done over the last 5 quarters, and that's how we've really focused the R&D spend. We spend between 3.5% and 4% of our revenue, it's close to $700 million a year in IRAD. It's augmented by customer funding, but a lot of IRAD commitment here remains high. We focused our portfolio, reduced the number of projects by about 1/3, shifted our dollars around by about 10%, 15% to really focus on those areas, those threats, those technologies that enable the future fight. And it's around open architecture system, multifunction, software-defined, everything in all of our solutions, really geared towards war fighter effectiveness, spectrum, superiority, actionable intelligence, and that's really what has been the focus. We think the investments in technology is what's going to allow us to differentiate our offering into the future.

Yes. And I guess maybe on that R&D effort and one of the areas that you've highlighted quite a bit on the building blocks for revenue. Is on the revenue synergy side. Maybe you could talk a little bit how that is coming together? You gave us a good update, most recently on the Q3 call.

Well, this has been a great surprise. And the team has done a great job here in driving revenue opportunities. So we have about 80 proposals now that have been submitted. We've had 37 have been awarded. We've won 25 of 37, so more than. 50%, it's a pretty good win rate, about 2/3, about $300 million worth of awards that we received. We have a very large multibillion-dollar pipeline. It continues to grow. We continue to add ideas to the list. We talked on the call about winning the SDA tracking layer, which was a revenue synergy between opportunities that we had from Harris and the space domain with the avionics side from L3 which enabled that win. And we see revenue opportunities continuing to grow and ramp. We see it growing to hundreds of million dollars in '21 and '22 and beyond. So great progress here, great momentum that's been built. And I think we're still at the front end of it.

That's great. That's great to hear. I know everyone's focused on that and continues to enjoy those updates that you give us. A third leg, I think, of your kind of building box is international, I think about 20% of your revenues. How do we think about just the opportunities here to kind of leverage your scale and kind of get further penetration across the board, and I think leveraging kind of the ISR leadership that you have?

Well, ISR is one important area. So we are under-penetrated in our view, about 20% of our revenue is coming from international. We spent the last 9, 10 months really organizing ourselves going after the international opportunities. 10 different focus countries across the Middle East, Asia, Canada, U.K. and we're really attacking this. So ISR monetization is one important area. So you can see what's happening in the DoD. You're putting ISR systems on to business jets. And that opportunity is leveraging itself internationally. There's ISR opportunities in the maritime domain. And certainly, there's a pretty aggressive build-out of opportunities on the tactical side as well as night vision goggles. So there's lots of opportunities in those soldier systems, missionization of aircraft, driving more in the maritime domain, and we're really attacking this opportunity. We saw good growth here in the third quarter. We'll see good growth again in the fourth and into next year. As we look into next year, we see mid-single-digit plus growth in international. Despite some challenges in the international budgets, we see ourselves well positioned there. Pipeline is quite large. And I think we're building momentum on international.

That's great. One of the questions we get from investors is concerns around operations and maintenance exposure. I guess, if we want to put it in shorter cycle exposure, maybe just maybe we could flush that out, how you view that and how investors should think about that with L3Harris?

Well, first off, O&M is about 20% of total L3Harris sales, about 40% of DoD, it's about 20% of the total company. And as a lot of this aircraft ISR, that's a big part of it. Programs that have very long multi-decade support by Congress, they're performing essential missions, things around big safari programs with aircraft operating overseas. So it's very well supported. And we tend to see history showing O&M to be pretty steady in shifting budget trends. So I think that feels pretty good. In terms of this question around short cycle, we have about $21 billion in funded and unfunded backlog. We reported that in Q3 in our 10-Q. It's about 1.5 -- 1.5 -- 1.15 to 1.2x our revenue in that order of magnitude. We have about 2/3 of our revenue over the next 12 months, that's in backlog. Peers and other providers are typically in about 80% range. So I think we are shorter cycle, but not necessarily short cycle. Because even those parts of our business that are shorter cycle in nature, things like tactical radios, night vision goggles, the majority of that revenue is from programs of record now that have extended visibility into the budgets. And we're at the front end of what we see to be multiyear modernization cycle. So just take DoD tactical radio for a moment. There is about 350,000 to 400,000 radios that will be modernized over time in DoD so far to date, we've only -- the market has only bought 40,000 radios. It's only about 10% of the way through that path. It's us and other competitors. About 10% has been awarded to date and you can see the ramp. The ramp remains there. It's well funded. It's well protected. Similarly, on the international side, we talk a lot about what's driving international growth. There's some multiple countries that are starting on long-term modernizations that look like DoD lagged by a bit. There's the total opportunity international, over 200,000 radios. It's about $4 billion in size. And it's things like U.K., the Morpheus program, we've talked a lot about that. It's Australia, it's New Zealand, a variety of NATO countries, Saudi Arabia, Algeria, a bunch of -- Ukraine, a bunch of countries that are embarking on multiyear monetizations, which we think has a long tail to it. And similarly, night vision goggles, we're very well protected here. We are -- we're the sole source provider for the director requirement on ENVG-B, the next-generation night vision goggle, it's about 10,000 units. We've delivered 5,000. But we just were announced with an LRIP on the program of record for ENVG-B. It's a 100,000 goggles over time. And again, we're about 5,000 and that's about 5% into that path. So very -- at the front end of multiple paths of long-term modernizations which I think have really good visibility in terms of budget. So even though it's shorter cycle in terms of booking and shipping within a year, much greater visibility than we've had for a long period of time, Peter.

Yes. That's excellent. I was going to ask about that modernization on the radio side, so that was a terrific answer. Thank you for that. On space, maybe there's just a ton of interest on defense community. What opportunities, I think, are you calling out, I think you've called out quite a bit of, I think, synergies that have happened just between the complementary portfolio within L3 and legacy Harris.

No. I think space is a very exciting domain. It's a big part of the company. We were down year-to-date in the third quarter. We had a very strong book-to-bill in the third quarter, funded and unfunded at about 1.7. We will see growth in the fourth quarter. We'll see growth in the space domain next year. And this all goes back a number of years to this transition that we're making from providing exquisite components which are very, very important, both optics and RF capabilities and broadening that offering to become more subsystems and now full end-to-end mission solutions. So we're flying more than 5 smallsats today. They're operating very, very effectively. They're low cost, they're very responsive. We will launch from -- order to launch in under 2 years. And that's opening up a very important new market in the Department of Defense. Most of legacy systems were sold into the intelligence community. It's opening up a whole new big market for us. And we think we're very well positioned here in terms of growth. What's driving this is all about resiliency and the risks we see to the overhead architecture and the need to move to hosted payloads or resilient small satellite systems to disaggregate capability. I think we're a few years ahead of most of the competitors in the space. You saw we won SDA tracking. There's multiple other opportunities that are in competition today, some for missile defense, like tracking and a lot in more of the intelligence community where we're seeing a long-term transition from airborne capabilities moving into the space domain, given the fact that the fight of the future is going to be a nonpermissive space. So we're at the front end of a long journey. We're winning a lot. We're extremely well positioned. A lot of our IRAD dollars is focused in that area. And we think we'll see continued growth in '21 and beyond in the space domain.

Yes. On the R&D spending, I guess, longer term, is there a specific percentage that you're targeting? And one of the areas that I think the topic that comes up recently is around 5G in regards to the DoD. Are there any impacts there that you're seeing or having to step up more on the R&D front?

No, I think our R&D is well sized. I mean, we'll move it up or down a little bit based on the opportunities to invest that we see inside the company. I don't think we're constrained there. And we do invest quite heavily. Right now, we're focused on making sure we're putting those dollars in the right place. So on the right project. So that's all about the sort of the effectiveness but we'll also working the efficiency angle, trying to make sure we get more bang out of the dollar that's going in for IRAD. And that's driving digital engineering. It's driving agile software development. It's managing the metrics of how we execute on electrical design, mechanical design, software design. So we're really focused on this. And this I think is a very important lever. So you may see R&D move up a little bit over time. It's certainly going to move up with sales. But we're investing fully in the opportunity we have ahead of us. Now in 5G, it's very interesting. We're obviously a broad C5 ISR company, so communications and waveforms and links between sensors and platforms is very important. 5G will have some role in that in the future. There's been a ton of buzz around 5G the department is really studying this hard, putting some contracts out. A lot of it is for sort of test cases, if you will, experimentations on how you can leverage 5G in things like synthetic training in warehousing and logistics. There's certainly money going into the developing tools for how do you share that spectrum that sub-6 gigahertz spectrum with the cell carriers, we see it as beachfront property. The FCC has demanded that. So that's a big part of this as well and then driving security into 5G. So we're around the fringes of that piece, but we're more interested in is how could you use 5G in a mission setting. That's still a little bit into the future. It is it's not as resilient. It's not a cyber-secure. There's lots of other communications, technologies, other wave forms LPI, LPD, anti GM type wave forms that go below the noise floor, optical communications, there's lots of different technologies that go beyond 5G to connect these various sensors and platforms in real time, that I think we're right in the middle of. So we've got to stack across all these different technologies, all these different spectrum bands in different wave forms. I think we're a leader in waveform development. And as I think about the investment we're putting into waveform, it's probably one of the biggest investments in IRAD we're making side the company. So we'll be a player here, Peter, whether it goes 5G or something other than 5G, but we're going to be in the middle of this.